Thursday September 29, 2011
by Mark Salzinger, editor The No-Load Fund Investor
T. Rowe Price recently unveiled a new bond fund: Price Floating Rate (PRFRX) -- a welcome addition to the mutual-fund universe. Floating rate bonds are typically issued by companies with credit ratings that are below investment grade.
This fund as one of only two no-load mutual funds to invest solely in floating rate issues (Fidelity Floating Rate High Incomeis the other.)
To entice investors, such bonds have several attractive features, such as favorable standing in creditors’ pecking order and an interest-rate reset feature that causes interest payments to increase when prevailing rates rise.
The rates paid on floating rate bonds are determined based on a ‘spread’ relative to an interest-rate benchmark, often LIBOR.
If LIBOR were currently 2% and the spread on a particular floating rate bond were two percentage points, the borrower would pay 4% interest.
Every 30 or 90 days, the interest rate would reset. If rates were falling, the borrower would pay less interest, but if rates were rising, the lender (the bondholder) would get a larger interest payment.
Therefore, the prices of such bonds suffer little if any damage when interest rates increase.
The risk inherent in floating rate bonds is therefore effectively limited to the perception of the creditworthiness of the borrower, and T. Rowe Price has established a reputation for careful analysis of bonds with credit that rates below investment-grade.
Price Floating Rate is run by Justin Gerbereux and Paul Massaro, both of whom have served as analysts for Price High Yield, a relatively moderate high-yield fund with a solid performance record.
Earlier this year, floating rate bonds had attracted significant investor interest in anticipation of higher interest rates. Since then, economic growth has slackened and the Federal Reserve has pledged to keep interest rates low.
The reversal in expectations, combined with fears of a double-dip recession, led to a sharp sell-off in floating rate bonds.
However, that has made them a relatively better buy at recent levels. Because the fund is new, there is little data available about its holdings, but we were told by Price that the average yield on the funds’bonds is 5.5%.
Keep in mind that though this yield may seem attractive relative to those of very short-term Treasuries, floating-rate bonds would be expected to produce significant losses during recessions or other periods of financial distress.
However, so long as the economy avoids another recession, the fund is likely to perform fine. Price Floating Rate has a 0.85% expense ratio, which is not out of line relative to Fidelity Floating Rate High Income’s 0.73%.
Learn more about this financial newsletter at Mark Salzinger's No-Load Fund Investor.